Perspectives on where our world is heading from a vantage point in Denver, Colorado.

04 February 2010

Should Chapter 11 Be Reformed?

A brief academic review of the General Motors and Chrysler bankruptcies argues that the controversial swift sales of the companies in those cases that left creditors to fight over the sale price were well within established precedents for bankruptcy law and simply flow from the power bankruptcy law afford to secured creditors and to parties providing funding for the companies while the reorganization is pending (debtor-in-possession lenders aka DIP lenders, in these cases, the U.S. government).

Thus, if something went wrong in these cases, it did so because the system was broken, not because the judges or participants did something wrong given the rules that they had at their disposal. What might have been wrong (citations omitted and paragraph breaks modified for ease of reading, emphasis added)?

Modern Chapter 11 . . . is not merely a traditional reorganization procedure in which debts are restructured or reduced and equity is redistributed to existing creditors. That process has long been criticized as one that is vulnerable to the biases of judges and to jockeying and holdup by creditors and equity holders. Eastern Airlines has long been the poster-child for these problems.

Nor is the modern Chapter 11 merely a speedy auction in which firms are routinely sold off. That process has likewise been the object of much criticism because it can prematurely expose a firm to the market, generate firesale prices with correspondingly low returns to unsecured creditors, and yield a (temporary) misallocation of resources. . . .

The outcome—a traditional reorganization or a speedy auction—depends on the bargaining power of the various constituents. A powerful DIP lender can push for a speedy sale, as it did in the Chrysler bankruptcy, possibly at the expense of other creditors. Junior creditors can push back and delay the bankruptcy process in hopes of at least a small recovery. . . .

For example, one study shows that a Chapter 11 is more likely to end in a sale when secured lenders are oversecured and therefore unconcerned about the risk of a fire sale. Sales are significantly less likely when a firm has no secured debt and when secured claims exceed the value of the firm’s assets. Another study suggests that the recoveries of unsecured creditors are substantially lower when a firm is sold off through § 363 than when it is reorganized. . . .

Some studies have found that the bankruptcy process is no more costly than comparable change-of control transactions, that the costs of this process are small compared the costs of financial distress generally, and that firms in bankruptcy are no less efficient in allocating productive resources than firms operating outside bankruptcy. Then again, it is difficult to disentangle the costs of our bankruptcy system from the costs of financial distress generally, because the law affects the resolution of distress in or out of court. And one recent study suggests that the expected cost of financial distress may be as high as 4.5% of the pre-distress value of the firm’s assets.

The article also cites four academic proposals for Chapter 11 reform without discussing them. They are:

My intuition is that the pendulum currently favors quick asset sales and FDIC style takeovers relative to detailed traditional reorganizations for large companies due to concerns about systemic risk informed by the financial crisis which was an indirect cause of the GM and Chrysler bankruptcies.

One intermediate approach that I have advocated is to limit reorganizations to long term financial debt where possible. The article discussed at length the fact that it is routine in Chapter 11 bankrupticies for trade creditors with theoretically lower priority than financial creditors to be paid in order to make the surviving company viable.

A more direct and targeted reform would be to simply raise the threshold that must be met for a § 363 sale of a company in cases where it is requested by an oversecured creditor over the objection of unsecured creditors.